FIN 502 Business Finance

Lecture 11: Risk and Return

Professor Ran Duchin

Foster School of Business

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 Roadmap
 Evaluate investments: (1) discount rate; (2) Cash flows

 In this part of the course we turn our attention to the first item,
i.e., estimating the discount rate

 Goal: Add value by undertaking positive NPV investments

 Positive NPV investments earn greater expected return
than investments in the financial market of similar risk
 Therefore, we need to know how risk and return are
measured and related to one another in the financial market

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Value of $100 Invested at the End of 1925

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 Realized Stock Return
The realized return from your investment in the stock from t to t+1 is:

Divt 1  Pt 1  Pt Divt 1 Pt 1  Pt
Rt 1   
Pt Pt Pt
 Dividend Yield  Capital Gain Yield

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 Example 1:Realized Return
Suppose you bought Microsoft stock for $106.86. After you
bought the stock, Microsoft paid a one-time special dividend
of $3.08. You sold the stock immediately after the dividend
was paid for $105.05. What was your realized return from
holding the stock?

𝑅 3.08 105.05 106.86 /106.86 1.2%

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 3.08/106.86 2.9%
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛 𝑦𝑖𝑒𝑙𝑑 105.05 106.86 /106.86 1.7%

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 Stock Return and Dividend-
Adjusted Prices
 To facilitate calculation of dividends, Yahoo Finance reports adjusted
closing prices for all stocks, and these adjusted closing prices
already include dividends paid

 The return formula can be simplified by using adjusted prices:

Stock Return = (Pt+1, div-adjusted – Pt, div-adjusted) / Pt, div-adjusted

 Pt+1, div-adjusted – dividend-adjusted stock price, end of period

 Pt, div-adjusted – dividend-adjusted stock price, beginning of period

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 Compounding Returns
 The annual realized return, Rannual, is found by compounding:

1 𝑅 )= 1 𝑅 ) 1 𝑅 · ⋯· 1 𝑅 )

 Example: Netflix’s annual return using monthly returns

May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18

-8.38% 21.58% -3.83% 3.80% 8.32% -4.51% 2.34% 40.81% 7.80% 1.36% 5.79% -0.25%

1 𝑅 1 𝑅 1 𝑅 … 1 𝑅

1 𝑅 1 0.0838 1 0.2158 … 1 0.0025

𝑅 1.911 1 0.911 91.1%

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 Average Annual Returns
 The arithmetic average (mean) annual return:

1
R  ( R1  R2  ...  RT )
T

 The geometric average (mean) annual return:

1/T
Geometric average return = [(1+ R1)(1+ R2) … (1+ RT)] – 1
Or
1/T
Geometric average return = (PT, div. adjusted / P0, div. adjusted) – 1

 The geometric average return is also known as the compounded

annualized return or CAGR – Compounded Annual Growth Rate

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 Relationship between Arithmetic and
Geometric Averages
 For any sequence of historical returns:

Arithmetic ave. return ≥ Geometric ave. return

 The higher the volatility (variability) of returns in time, the larger

the difference between arithmetic and geometric averages

 Intuition
 The arithmetic average assumes that if a $100 stock goes down by
10% and then goes up by 10%, it will have a zero return
 In reality, the return in the above example will be negative (-$10 +
$9 = -$1) because the 10% increase is based on a smaller value
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 Example 2: Arithmetic and
Geometric Average Returns
The table below shows div-adjusted values of the SPDR S&P 500
(SPY) on the same date, November 7, (or closest trading day) over the
past decade. Compute the mean 10-year annual return and CAGR.
Year Price Return = (P1 –Po)/P0
2019 306.67224 11.85%
2018 274.18658 10.62%
2017 247.86377 23.81%
2016 200.1944 3.67%
2015 193.1153 5.38%
2014 183.254 18.50%
2013 154.6427 27.94%
2012 120.8714 13.03%
2011 106.9373 5.13%
2010 101.7219 16.60%
2009 87.24255 10
 Example 2: Mean and CAGR Returns

 r mean = (r1 + r2 + r3 + r4 + r5 + r6 + r7 + r8 + r9 + r10)/10

r mean, S&P 500 = 13.65%

1/10
 r CAGR = [(1+r1)(1+r2)(1+r3)(1+r4)(1+r5)(1+ r6)(1+ r7)(1+ r8)(1+r9)(1+r10)] –1
r CAGR, S&P 500 = 13.40%

Shortcut: we can compute CAGR based on the beginning and ending prices:
r CAGR = (Pn / P0)1/n – 1= (P2019 / P2009)1/10 – 1
r CAGR, S&P 500 = (306.672241 / 87.242554)1/10 – 1 = 0.134 = 13.40%

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 Defining Risk
Risk is related to the probability and magnitude of obtaining
outcomes that are other than their expected value

 Why does risk matter?

 It is generally assumed that people do not like risk
 They will require a reward commensurate with the risk they take
 But why do people gamble? Play the lottery? The expected
outcome in both is a loss

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 The Variance and Volatility of Returns
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 Variance: Var  R  
T 1
 ( R1  R)2  ( R2  R)2  ...  ( RT  R)2 

 Standard deviation: SD ( R )  V ar  R 

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 Example 3: Historical Volatility
What is the standard deviation of small stocks’ returns over the
period 2009-2014?

2009 2010 2011 2012 2013 2014

-39.12% 50.48% 31.54% 7.40% 15.39% 28.29%

 The average annual return for small stocks is:

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𝑅 .3912 .5048 .3154 .0740 .1539 .2829 .1566 15.66%
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 We now have all of the necessary inputs to calculate the variance:
1
𝑉𝑎𝑟 𝑅 𝑅 𝑅 ⋯ 𝑅 𝑅
𝑇 1
1
.3912 .1566 ⋯ .2829 .1566 0.0939
6 1
 Example 3: Historical Volatility
 Alternatively, we can break the calculation of this equation out as
follows:
2009 2010 2011 2012 2013 2014
Return -0.3912 0.5048 0.3154 0.0740 0.1539 0.2829
Average 0.1566 0.1566 0.1566 0.1566 0.1566 0.1566
Difference -0.5478 0.3482 0.1588 -0.0826 -0.0027 0.1263
Squared 0.3001 0.1212 0.0252 0.0068 0.0000 0.0159

 Summing the squared differences in the last row, we get 0.4693

 Finally, dividing by (6-1=5) gives us 0.4693/5 =0.0939
 The standard deviation is therefore:

𝑆𝐷 𝑅 𝑉𝑎𝑟 𝑅 0.0939 0.3064, 𝑜𝑟 30.64%

 Our best estimate of the expected return is the average return,
15.66%
 Small stocks are risky, with a standard deviation of 30.64%
 Risk and Return in Financial Markets

Small Stocks 21% Small Stocks 42%

S&P 500 12% S&P 500 21%

Corp Bonds 7%
Corp Bonds 8%

Govt Bonds 5%
Govt Bonds 3%

0% 5% 10% 15% 20% 25%

0% 10% 20% 30% 40% 50%
Average Annual Return (% )
Standard Deviation of Returns

The market risk premium: Stock Returns – Return on Treasury Bonds

7% = 12% -5%

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Risk and Return in Financial Markets

3-mo Treasury Bills

AAA Corporate Bonds

S&P 500
Frequency (# of years)

Small Stocks

-60% -50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% >100%

Annual Return

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Historical Tradeoff: Risk and Return

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 Confidence Intervals

 The Normal Distribution: 95% Prediction Interval

Average  (2 x standard deviation)
R  (2 x SD  R  )

 About 2/3 of all possible outcomes fall within one standard deviation
above or below the average

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 Example 4: Confidence Intervals

 The average return for small stocks from 2009-2014 was 15.66%
with a standard deviation of 30.64%. What is a 95% confidence
interval for 2015’s return?

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 2 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛

15.66% 2 30.64% 𝑡𝑜 15.66% 2 30.64%
45.62% 𝑡𝑜 76.94%

 Even though the average return from 2009-2014 was 15.66%, small
stocks were volatile, so if we want to be 95% confident of 2015’s
return, the best we can say is that it will lie between -45.62% and
+76.94%.

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 What Can We Learn from Historical
Returns?
 Mutual funds often advertise their historical returns as an indicator
of managerial ability

 About 43% of all printed mutual fund advertisements refer to past

performance

 This marketing approach has been documented to generate strong

capital inflows into the advertised funds

 Can we benefit from seeking funds with high recent returns?

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Last Year’s and Next Year’s Returns
of Mutual Funds
Future returns over the next 12 months

TTM Past 1st Quartile 2nd Quartile 3rd Quartile 4th Quartile
Returns (%) (%) (%) (%)

1st Quartile 21.45 20.91 25.27 30.00

2nd Quartile 23.32 27.32 24.04 20.04

3rd Quartile 25.68 22.77 22.77 21.49

4th Quartile 21.27 21.64 20.73 24.91

Source: S&P’s Mutual Fund Performance Persistence Scorecard

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 Summary
 Realized Stock Return
 𝑅 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛 𝑌𝑖𝑒𝑙𝑑

 Arithmetic and Geometric Averages

 r = (r1 + r 2 + … + r T) / T
mean
1/T
 r CAGR = [(1+ r1)(1+ r 2) … (1+ r T)] – 1
 r mean ≥ r CAGR

 Variance
1
 Var  R  
T 1
 ( R1  R)2  ( R2  R)2  ...  ( RT  R)2 

 Historical Tradeoff between Risk and Return

 Confidence Intervals 23